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Keith Siilats, Friday 2pm

The most (a) encouraging (b) discouraging aspects of the UK's current economic position. Give QUANTITATIVE as well as analytical support for your answer.

Encouraging aspects.

I think that there are three encouraging aspects in the UK economy today. Firstly the European Union policies are finally managing to bring some new ideas into the economic policy in Britain. Secondly the government has managed to stick to the target level of inflation under 2.5% for quite a while, signaling that the policy of making the government more open has been successful. Finally, the New Labor policies in labor markets have been quite beneficial. This has allowed UKís economy to grow over the past years, and I think, will allow her to land softly as well.

 

It is very hard to quantify the effects that the European Union has for Britain as of present. The opening up of capital markets and the uniform labor regulation has definitely been beneficial, as seen by the increased foreign direct investment and falling unemployment (ILO measure is 6.3% down from 9% a year ago). In the past, inflation would have risen long before unemployment fell to these low levels. However, the inflation has not started to increase. The OECD estimates that in 1990 Britainís NAIRU was about 8.5% (on the ILO measure). It thinks that by 1997, thanks in part to reforms which have made the labor market more flexible, the NAIRU was down to 7.2%. The IMF puts it slightly lower, at 6.7%. It still seems that inflation should start rising, however, it is probably not rising at present due to high exchange rate. The overrating of exchange rate is very hard to quantify analytically.

Industrial production has also been growing fast in the past few years. For most other countries the most remarkable effect has been the reduction of volatility of financial markets, however, as Britain is not joining EMU, its currency volatility has remained the same.

 

The government openness about publishing different forecasts of the economy, making the central bank more independent and actually estimating the probability distribution of its estimates has made the policies more transparent and reduced the uncertainty. It has definitely opened up the government for short-term criticism (for example because of its aims to increase the government spending), but in the long-run it will benefit investment. Again the exact effects are very hard to quantify exactly, however, the predictions of government have become progressively better. Bank of England must write an open letter if the inflation is above or below the target 2.5% by more than 1%. When previously the chance of this occurring was thought to be 50% in any year, it has now fallen to 30%.

 

The New Labor has made two major changes to the labor market, it has set a minimum wage and has reformed the welfare system to encourage participation. Although these two changes should have offsetting effects on the unemployment, the actual unemployment rate has been falling rapidly. However, the long-run effects of the artificial job creation could prove to be less beneficial as the labor productivity of the nation will start falling as the previously unemployed people should have lower productivity.

 

Discouraging effects.

There are two main types of discouraging effects at present: those arising from international turmoil and those arising from the old labor type of policies that the government is using increasingly.

The financial crisis started a year ago from Asia and has affected the whole World economy. At present even prestigious hedge funds like the Long-term Capital Management are having problems. As a result the stock market has fallen by 4.3% over the past year in Britain. This will make new share issues less likely, firms will have fewer resources for investment and economic slowdown will result. However, on the other hand the growth of stock market had been quite prolonged and many companies might have found it more profitable to invest to that, rather than invest into production. Anyway, the world seems to be recovering from the shock already, with the stock market increasing by 4.3% last week. However, the volatility has increased permanently and this will have very long-lasting effects in terms of increased uncertainty and increased cost of hedging the risks.

 

The government policies have recently come under a lot of scrutiny. Its spending plans were recently revised up, causing the debt and PSBR to increase. This will likely crowd out the private investment. Furthermore, the high interest rates have caused the pound to appreciate significantly, causing the exports to diminish which has resulted in the trade balance being red again (-2.3b) after being positive at the beginning of this year. If one believes in Keynes, this should bring about a reduction in GDP larger than the reduction in exports due to multiplier effects.Furthermore, if Britain has to join EMU with that high exchange rate, the labor competitiveness would be seriously damaged and it would take a few years for the productivity to become equalized with Europeís one. On the other hand, the creation of EMU will make other currencies to depreciate, thus if Britain is not hurrying to join the EMU, there is not that much need to worry about the temporary high exchange rate.

 

It is clear that British economy was overheating. However, the magnitude is not clear, thus the main forecasts that the cooling procedure was too intensive can not be relied on extensively. At present the GDP is growing a bit over 2% a year, however, the forecast for 1999 is only 0.8% (The Economist). It is unlikely that with the increased public spending the growth is actually going to be that low. However, the only thing that can be predicted with certainty, the volatility of the markets and economic measures, has increased due to the many shocks. And if one believes in risk aversion theory, this should cause the economies to grow more slowly until the confidence is re-established and the psychological effects of shocks have eroded.

 

 

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